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DISCUSSION PAPER PI-0003

Stochastic Lifestyling: Optimal Dynamic Asset Allocation for
Defined-Contribution Pension Plans

Andrew J.G. Cairns (Heriot-Watt University)
David Blake (Birkbeck College, London)
Kevin Dowd (Sheffield University)

SUMMARY

This paper considers the asset-allocation strategies open to members of
defined-contribution pension plans. We investigate a model that incorporates
three sources of risk: asset risk and salary (or labour- income) risk in the
accumulation phase; and interest-rate risk at the point of retirement. We
propose a new form of terminal utility function, incorporating habit formation,
that uses the plan member's final salary as a numeraire. The paper discusses
various properties and characteristics of the optimal stochastic asset-allocation
strategy (which we call stochastic lifestyling) both with and without the presence
of non-hedgeable salary risk. We compare the performance of stochastic lifestyling
with some popular strategies used by pension providers, including deterministic
lifestyling (which involves a gradual switch from equities to bonds according to
preset rules) and static strategies that invest in benchmark mixed funds. We find
that the use of stochastic lifestyling significantly enhances the welfare of a wide
range of potential plan members to these other strategies.

ISSN 1367-580x.